Latest / How Canadian Markets Work / Episode 93: Risk and Return (The Sequence Trap)

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Episode 93: Risk and Return (The Sequence Trap) · How Canadian Markets Work

0:00
You know, if you're willing to sacrifice like
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86 % of your market upside just to guarantee
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your principle in a structured product like those
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principle protected notes and market linked GICs
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we focused on in our last deep dive, you aren't
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actually avoiding risk. No, not at all. You're
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really just trading a highly visible noisy risk
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for a completely invisible silent one. Oh, absolutely.
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And I mean, it is a trade. the financial industry
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is more than happy to facilitate for you. Usually
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for a very handsome, very hidden fee, you basically
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end up exchanging the immediate discomfort of
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watching your account balance fluctuate for the
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absolute certainty of lost opportunity and inflation
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erosion over time. Well, welcome to the deep
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dive. It is fantastic to have you here with us
0:46
for what is essentially our risk and return masterclass.
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It's going to be a fun one. Yeah. because today
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our mission is to completely dismantle the financial
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industry's default definition of danger. We're
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going to look beyond standard deviation, examine
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the undeniable math of how two portfolios with
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identical average returns can leave a retiree
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with vastly different account balances and help
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you define your own personal risk profile rather
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than reflexively adopting Wall Street's deeply
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flawed metrics. Which is so important right now.
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It really is. Okay, let's unpack this. We pay
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incredibly hefty fees for those protected products
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because we are terrified of a single word which
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is volatility. Or volatility. But I struggle
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to understand why the finance industry treats
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volatility as the ultimate boogeyman. Like, why
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is standard deviation the golden rule of risk?
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Well, honestly, it mostly comes down to convenience.
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Really? Just convenience? Yeah, pretty much.
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Standard deviation is just a statistical measurement
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of how much a set of returns varies from its
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own historical average. So the industry uses
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it because it fits neatly into their models,
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you know, and their spreadsheets. It's just very
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easy to quantify. So it's basically a math shortcut.
1:59
Exactly. When a financial advisor looks at a
2:01
mutual fund and flags it as high risk on a chart,
2:05
they're almost always just looking at a backward
2:07
-facing metric of how bouncy the price has been
2:10
over the last three or five years. See, I have
2:12
to push back on the idea that bouncy equals dangerous.
2:15
Go for it. Because it feels like we're equating
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a bumpy ride with, like, a fatal disaster. If
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I'm flying across the country, turbulence might
2:24
spill my coffee, right? Sure. It might make my
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stomach drop. And honestly, it can feel absolutely
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terrifying in the moment. Oh yeah. Nobody likes
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turbulence. Exactly. But turbulence is volatility.
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It is not the plane crashing. Right. That's a
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great way to look at it. And the math Wall Street
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uses seems completely blind to context and direction.
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Like, if a stock I own unexpectedly shoots up
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20 % in a single month because of a great earnings
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report, Standard deviation records that wild
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upward swing as highly risky, which is crazy.
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No investor in the history of the world has ever
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looked at a surprise 20 % gain and thought, oh,
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no, I'm an incredible danger. Yeah. I mean, that
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framing highlights the core flaw perfectly. The
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math just doesn't care if. This surprise is a
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windfall or a catastrophe. It only cares that
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it was a surprise. But let's look at this from
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the perspective of someone who is actually holding
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an investment for the long haul. For a true holder,
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like someone who doesn't sell their shares, volatility
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literally isn't a loss. It's just noise. Exactly.
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It is simply fluctuation on the way to an eventual
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outcome. The paper value of your portfolio might
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swing wildly from day to day, but your actual
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ownership of the underlying companies hasn't
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changed by a single fraction of a percent. Right.
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You still own the exact same number of shares.
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Which means volatility only transforms into a
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permanent risk when human behavior gets involved.
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Oh, right. It becomes a risk when the turbulence
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panics you into selling at the absolute bottom.
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Or, unfortunately, when unexpected life circumstances
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force your hand. Like a medical emergency or
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something. Yeah, exactly. A sudden medical bill
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or maybe a job loss where you are forced to sell
4:05
your assets into a declining market just to raise
4:08
cash. If you don't sell, the bounciness is largely
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just noise. So if volatility is just the turbulence
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spilling our coffee, then Wall Street seems to
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be pointing us at the wrong threats entirely.
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They often do. What is an actual financial plane
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crash look like? I mean, what are the mechanisms
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that actually wipe out wealth permanently? So
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true risk is in fluctuation. True risk is the
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permanent loss of capital. Meaning the money
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is gone. It's when your money is gone and it's
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never coming back, no matter how long you hold
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on. And rather than just giving you a textbook
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list of terms, look at how a couple of these
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mechanisms actually operate in the real world.
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OK, lay it on me. Take credit risk, for example.
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We see this a lot with corporate bonds. You loan
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a company your money, they promise to pay you
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interest, but then their business model fails.
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They go under. Right, they go bankrupt. They
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simply default on the debt. At that point, it
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doesn't matter if you have the psychological
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fortitude to hold that bond for another 40 years.
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The money has completely vanished. Exactly. The
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company literally ceases to exist, so the asset
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goes to zero. Yes. What about something more
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systemic, like liquidity risk? I hear that term
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thrown around a lot. Yeah. But I always assume
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if I own something valuable, there will eventually
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be a buyer for it. See, that is a very dangerous
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assumption. Really? Yeah. Liquidity risk is the
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danger that you desperately need to sell an asset,
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but the market of buyers completely evaporates.
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Just gone. Just gone. Think back to the 2008
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financial crisis, particularly with certain types
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of real estate or, you know, those complex mortgage
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-backed securities. Oh, right, right, the toxic
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assets. Exactly. You might have held a piece
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of paper that a rating agency said was worth
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a million dollars, but when you tried to sell
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it, the phones literally stopped ringing. Wow.
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The actual bids coming in were for pennies on
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the dollar, or worse, there were zero bids. Nobody
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wanted to touch them. Right. So if you are forced
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to sell during a liquidity freeze, you take a
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catastrophic permanent loss because the paper
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value is entirely theoretical if no one is actually
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writing a check. Man, I'm putting myself in the
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shoes of someone listening to this right now.
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And if I'm hearing about corporate default and
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markets freezing over so completely that you
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can't sell an asset, My instinct is to run away.
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That's a natural reaction. Like, if all of those
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very real permanent loss risks exist out there,
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shouldn't you just keep everything in cash? I
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mean, cash doesn't default. True. Cash doesn't
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suffer from a lack of buyers. Haven't you successfully
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avoided the financial plane crash by just staying
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on the ground? Well, staying on the ground avoids
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the sudden crash, yes. But you end up booking
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a one -way ticket on a slow -sinking ship. Well,
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slow -sinking ship. Yeah. And that brings us
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to inflation risk, which is arguably the quietest
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and most insidious wealth destroyer of all. Because
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it's invisible. Exactly. The reason cash feels
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so comforting is because the nominal number on
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your bank screen never drops. If you deposit
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$100 ,000 today, you log in next year. And it
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still says $100 ,000. Right. There's no minus
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sign to trigger my panic reflex. Exactly. But
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inflation... is the guaranteed silent erosion
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of your purchasing power. If inflation runs at
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a historically normal 3 % a year, your $100 ,000
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still looks the same on the screen, but it buys
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3 % less of the world's goods and services. So
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it's basically an optical illusion of safety.
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That's a perfect way to describe it. Over 20
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years, that cash loses a massive chunk of its
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real world utility. So by holding cash, you are
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absolutely taking a risk. It's just a risk that
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doesn't set off for evolutionary alarm bills
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because it happens in slow motion. Exactly. You
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never see the money leave your account. You just,
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you know, slowly realize your grocery bill has
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doubled and cars cost twice as much as they used
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to. Yeah. So we are stuck. Cash guarantees a
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slow, silent loss of buying power, which forces
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us to invest. But investing brings all those
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permanent loss risks we talked about credit defaults
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liquidity freezes right back to the table. And
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what's fascinating here is how the market solves
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that exact dilemma through. The risk premium.
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The risk premium. Right. Think about it logically.
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If riskier assets, like stocks or long -term
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bonds, didn't offer the potential for higher
8:25
returns, no rational person would ever buy them.
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Why would you bother? Exactly. The market has
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to entice you out of your safe, slow -sinking
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cash position by offering you a premium. A reward
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for taking on the stomach ache of uncertainty.
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Yes, but the operative word is expected return,
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not guaranteed return. Ah, I see. If those higher
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returns were a certainty, the assets wouldn't
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be risky, and their prices would instantly adjust
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upward until the premium disappeared. You are
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paid that premium specifically because the final
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outcome is obscured. Meaning sometimes you lose?
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Right. Sometimes, instead of getting the premium,
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you will experience the downside. Here's where
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it gets really interesting, though. We've established
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that for a long -term holder, volatility isn't
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a permanent loss. And you must embrace that uncertainty
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to capture the risk premium. Correct. But everything
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we've discussed so far assumes you are just accumulating
9:18
wealth. What happens when you transition from
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being a holder to a withdraw? The game completely
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changes. Right. When you retire... you stop building
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the portfolio and you start pulling money out
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to pay for your groceries, your heating bill,
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your vacations. Because my understanding is that
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this life transition introduces something called
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sequence risk. Yes. And the math behind it is
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staggering. It really is. Sequence risk completely
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breaks the way we normally talk about average
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historical returns. OK. It is arguably the single
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most important mathematical concept for anyone
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approaching retirement to grasp. So how does
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it work? Let's break down how this actually works
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with a very specific scenario. Imagine you have
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a portfolio of exactly $1 million. OK, $1 million.
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And we're going to track it over just a three
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-year period with three specific annual returns.
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A fantastic year of plus 20%. Love that. A solid
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year of plus 10%. Right. And a brutal year of
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minus 15%. OK, let me track this. $1 million.
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We have a plus 20, a plus 10, and a minus 15.
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First, let's look at the scenario where you don't
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touch the money you make zero withdrawals. Just
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leaving it alone. Because of how compounding
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works over time, the order of those returns doesn't
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change your final number. If that terrible minus
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15 % happens in year one or if it waits until
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year three, your ending balance is exactly $1
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,122 ,000. The average return is the same and
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your final bank balance is identical regardless
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of the sequence. Right, because it's just a chain
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of multiplication. Exactly. Whether you grow
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the money first and shrink it later or shrink
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it first and grow it later, the final destination
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doesn't change. But now let's introduce the reality
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of retirement. Let's say you need to withdraw
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$50 ,000 at the end of each year to cover your
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living expenses. OK, so $150 ,000 pulled out
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over the three years. Right. Now, if you get
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lucky and the good years happen first, you get
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the plus 20. then the plus 10 and the minus 15
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hits at the very end. You take out your 50 grand
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each year, and you finish that three -year stretch
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with roughly $977 ,000 remaining in your account.
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That feels like a massive win. I started with
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a million, lived my life, spent 150 grand, and
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my portfolio is still hovering right around where
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it started. It's a great outcome. But now, let's
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keep the exact same portfolio, the exact same
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three returns, and the exact same average annual
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return, but we are going to reverse the sequence.
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Oh boy. You get terribly unlucky. The minus 15
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% hits in year one, right after you retire, then
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the plus 10, then the plus 20. Same numbers,
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different order. You still take out the exact
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same $50 ,000 a year to live, but in this reverse
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scenario, you end up with roughly $940 ,000.
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Wait, hold on. It's the exact same investments,
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the exact same market performance over a three
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-year block. The only thing that changed was
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the order of the returns. And this retiree is
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$37 ,000 poorer. $37 ,000 poorer in just 36 months.
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That is wild. And if you stretch that dynamic
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out over a 25 or 30 year retirement, that mathematical
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quirk can quite literally be the difference between
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leaving a substantial inheritance to your kids
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or outliving your money entirely and going broke.
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I really want to dig into the mechanism of why
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that $37 ,000 gap opens up. Yeah, let's do it.
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Because it's easy to hear those numbers and think
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it's just spreadsheet magic. But what is physically
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happening in the portfolio? Think about unit
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prices. Right. When you are forced to withdraw
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$50 ,000 during that brutal minus 15 % market
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decline in year one, the price of your shares
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is depressed. They are on sale. Exactly. So to
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generate that same 50 grand in cash, you are
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forced to sell a significantly higher number
13:11
of mutual fund units or stock shares than you
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would have in a good year. You're hitting the
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nail on the head. You are liquidating a larger
13:18
percentage of your ownership stake. And once
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you sell those extra shares at a massive discount
13:22
just to keep your lights on, they're permanently
13:25
destroyed. Yep. They're gone. They're gone from
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your account. So when the market eventually recovers,
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when that plus 20 % year finally shows up, you
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have far fewer shares participating in the rally.
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That is the insidious nature of sequence risk.
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You are locking in the permanent loss of capital
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on a slice of your portfolio, and you are doing
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it at the absolute worst possible time. Because
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you had to eat. Right. Once cash starts flowing
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out of a portfolio, average returns become entirely
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meaningless. Wow. The only thing that matters
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is the sequence of what you experience when you
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start selling. And what blows my mind? is that
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sequence risk acts as a perfect mirror, depending
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on your age. Oh, completely. For a 22 -year -old
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just entering the workforce and putting $500
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a month into their 401k, a market crash early
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in their career is arguably the greatest mathematical
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gift they could ever receive. It absolutely is.
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Because they are accumulating, not withdrawing.
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Right. If the market tanks 15 % in their first
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year of working, their $500 monthly contribution
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is suddenly buying shares on clearance. They're
14:29
getting a They are accumulating a massive number
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of units at distressed prices, which will all
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compound explosively during the eventual recovery.
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So a retiree and a young worker can hold the
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exact same S &P 500 index fund, live through
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the exact same financial crash, and one of them
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is experiencing an unmitigated disaster while
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the other is being handed a generational wealth
14:52
building opportunity. That's the math. It proves
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that your phase of life completely dictates your
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danger level. Yes. Which leads to an obvious
15:01
question. If Wall Street's one -size -fits -all
15:04
volatility charts are broken, how do you actually
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measure your own personal risk? The most robust
15:10
way to evaluate your personal risk is to split
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it into two distinct separate dimensions. Okay,
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what are they? Risk capacity and risk tolerance.
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They sound similar, but they measure entirely
15:21
different things. How so? Writh capacity is strictly
15:24
arithmetic. It is the cold, hard, objective math
15:29
of what your current financial circumstances
15:31
can physically withstand. So capacity is the
15:34
spreadsheet. Right. Think of capacity like the
15:37
structural integrity of a ship's hull. Can the
15:40
steel mathematically survive a category five
15:42
hurricane without snapping in half? I like that
15:45
analogy. So if you are a retiree with a massive
15:48
defined benefit government pension that covers
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100 % of your living expenses, plus you have
15:53
Social Security, your capacity for investment
15:55
risk is incredibly high. Because your basic needs
15:58
are met. Exactly. Even if your investment portfolio
16:01
drops 50 percent, you won't miss a meal. You
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don't rely on those assets for your basic survival.
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Right. But if you have no pension, your income
16:08
is tied to commission based sales and you might
16:10
need to tap your investment accounts next month
16:12
just to pay your mortgage. Your capacity is near
16:15
zero. Yes. Because even a minor 10 percent market
16:18
dip might compromise your ability to literally
16:22
keep a roof over your head. Exactly. Okay, so
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if capacity is the physical hull of the ship,
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what is tolerance? Tolerance is pure psychology.
16:32
It is the mindset of the captain steering the
16:35
ship. Oh, okay. Does the captain have the emotional
16:38
fortitude to trust the instruments during the
16:40
storm, or do they panic because the waves look
16:43
terrifying and deliberately steer the ship directly
16:46
into a reef? I see. You might have the mathematical
16:49
capacity to endure a 40 % market crash without
16:52
it impacting your lifestyle, but if seeing your
16:55
portfolio drop by that much gives you debilitating
16:58
insomnia, ruins your relationships, and eventually
17:01
causes you to log into your brokerage account
17:03
to panic sell everything at the absolute bottom,
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then your tolerance is incredibly low. Right.
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It doesn't matter how strong the ship is if the
17:10
captain freaks out. This brings us to what I
17:12
consider the golden rule of behavioral finance.
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Between your capacity and your tolerance, the
17:18
lower of the two metrics must always dictate
17:20
your investment strategy. Because if you have
17:22
the high capacity of a billionaire, but the low
17:25
tolerance of a nervous wreck, your low tolerance
17:29
wins every single time. It overrides everything.
17:32
An aggressive optimized portfolio that you panic
17:35
sell at the worst possible moment is mathematically
17:40
disastrously worse than a suboptimal, highly
17:44
conservative portfolio that you actually have
17:46
the stomach to stick with through a crisis. The
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human behavior is a permanent part of the investment
17:52
return. You cannot separate the two. And, you
17:55
know, if we connect this to the bigger picture,
17:57
it exposes a massive measurement bias in the
18:00
way we talk about finance. The measurable risks,
18:04
the daily volatility, the credit ratings, the
18:06
standard deviation models, they get all of the
18:09
air time on financial news networks because we
18:11
can chart them. We can put them on a nice little
18:13
graph. Right. We can assign them a color and
18:15
put them on a screen. But the unmeasurable risks
18:17
are often the ones that completely alter financial
18:19
history. I think we naturally shy away from unmeasurable
18:22
risks because they feel like science fiction
18:24
until they happen. For sure. What kind of threats
18:26
are we talking about here? Yeah. We're talking
18:28
about things like sudden sweeping regulatory
18:30
changes. Imagine an entire industry's profit
18:34
margin being legislated away overnight. Like
18:36
a stroke of a pen. Exactly. Or massive geopolitical
18:40
events, conflicts that completely upend global
18:44
supply chains. Or, perhaps most common today,
18:48
technological displacement. Right, the classic
18:50
disruption model, where a completely new invention
18:52
makes a hundred -year -old legacy business obsolete
18:55
in an afternoon. Exactly that mechanism. You
18:58
cannot capture the risk of artificial intelligence
19:00
completely destroying a company's core business
19:03
model by looking at the last three years of that
19:06
company's stock price fluctuations. Because the
19:08
past data doesn't know about the future inventions.
19:11
Standard deviation is entirely blind to it. Yet
19:14
those unmeasurable structural shifts are the
19:17
actual plane crashes we talked about earlier.
19:19
We spend all of our energy obsessing over the
19:21
measurable turbulence on the radar, and we completely
19:24
ignore the unmeasurable mountains hiding in the
19:26
clouds. So what does this all mean? Let's bring
19:28
all these threads together for you. Number one,
19:31
the finance industry defaults to measuring risk
19:33
as volatility standard deviation, mostly because
19:36
it's easy maths for their software. Yep. But
19:39
true risk isn't the fluctuation of a price. It
19:42
is the permanent, irrecoverable loss of your
19:45
capital through things like credit defaults or
19:47
inflation. Spot on. Number two. Sequence risk
19:51
mathematically proves that average historical
19:53
returns are virtually meaningless if you are
19:56
withdrawing money in the wrong order. It breaks
19:58
the math entirely. Selling off your shares during
20:01
a downturn permanently destroys their ability
20:03
to participate in the eventual recovery. And
20:07
number three. Capacity and tolerance dictate
20:10
your true boundaries. You are a human being not
20:13
an algorithm. and the most dangerous risk in
20:15
all of investing is simply the one that causes
20:18
you to abandon your long -term plan at the worst
20:20
possible time. I think that captures the mechanics
20:22
of it perfectly. Risk simply isn't a single percentage
20:25
point on a fund's fact sheet. It is a highly
20:27
complex, highly personal intersection of broader
20:30
market mechanics, your specific phase of life,
20:32
and your own psychological endurance. I want
20:34
to leave you with a final, slightly provocative
20:37
thought to chew on today as we wrap up. Oh, I
20:39
like these. If the entire financial complex relies
20:43
on pushing these highly visible daily volatility
20:46
metrics into our faces, partially to scare us
20:49
into buying extremely expensive underperforming
20:51
products that cap our upside just to give us
20:54
the illusion of safety, is the ultimate financial
20:57
superpower, simply the discipline to stop checking
21:01
your portfolio balance altogether. That is a
21:03
great question. Think about it. If you don't
21:06
log into the app, you don't see the turbulence.
21:08
And if you don't see the turbulence, the invisible
21:11
emotional risks simply pass you by while you
21:13
stick to your plan. Ignorance can be a very profitable
21:16
strategy. Thank you so much for joining us for
21:18
this deep dive. We highly encourage you to sit
21:20
down tonight, look at your own circumstances,
21:23
and define your true capacity and tolerance,
21:25
rather than letting Wall Street define it for
21:27
you. We'll catch you next time.